All posts tagged German bunds

There is nothing like fear to focus the mind. And this could well be what is happening in Berlin after last week’s nasty little wake-up call when Germany failed to raise the funds it needed.

As long as investors were still buying German bunds, the debt crisis was still very much a problem for the rest of the euro zone as far as Berlin was concerned. But now that investors are shying away from German bunds, with German yields on the rise and German finances at risk, there appears to be a new urgency to find a solution.

Increased speculation of involvement by the International Monetary Fund, talk that Germany might be more willing to accept greater European Central Bank participation and moves towards greater fiscal integration that won’t involve long, dragged-out treaty changes have all emerged over the last few days.

A new poll showing German Chancellor Angela Merkel now has 55% backing for her policies towards the euro, as opposed to only 35% a few months ago, will certainly help give Berlin the confidence that it might have lacked before. There is optimism a new initiative will emerge as early as Tuesday, when euro zone finance ministers hold their next meeting.

The big fear of investors about the outlook for the euro has shown up in a hefty widening of sovereign spreads.

But a narrowing won’t necessarily be good news either. The increase in individual country risk premium across Europe’s periphery highlights the strains the single currency is suffering. The spreads over equivalent German bunds are read as a likelihood these countries default or leave the single currency and re-adopt their own currency.

But what if they don’t?

Almost certainly spreads would come in. That’s because either the European Central Bank will have started buying bonds or euro-zone governments will have agreed some formula of fiscal integration plus euro bonds. Not all of the narrowing, however, will come from demand for hitherto poorly performing sovereign debt. There will–or should–be a sell-off of core bonds at the same time.

Unsterilized ECB bond buying would be a strong signal that the central bank has abandoned its price stability remit and is willing to accept higher rates of inflation. This won’t be good for German bonds because that inflation is most likely to register in core countries whose economies are already operating at close to capacity.

“The [U.S.] deficit-reduction super committee, stuck in a partisan deadlock, faces an almost certain collapse — raising the threat of disruptive military spending cuts and a resurgent public anger at Congress as it struggles with the basic tasks of governance.

“Barring an unlikely, last-second breakthrough, the committee is expected to announce Monday that it failed to reach its mandated goal of writing a bipartisan bill to reduce deficits over the next 10 years by at least $1.2 trillion.”

Then read this one, from November 5, headlined ‘The Euro Crisis: Obama, on Periphery, Leaves Empty-Handed’. It explains how U.S. President Barack Obama went to the Group of 20 meeting in Cannes and “sought details of how euro-zone leaders would implement their emergency debt deal” before returning to Washington with many questions about the plan unanswered.

“I know it isn’t easy, but what is absolutely critical–and what the world looks for in moments such as this — is action,” Mr. Obama said.

If nothing else, the two stories highlight the lack of wisdom in criticising others for failing to do something you are unable to do yourself.

The euro zone’s debt crisis has seen a comprehensive move by investors into German bonds, first at the expense of ‘peripheral’ euro-zone paper and now, it seems, at the expense of every country in the bloc, triple-A-rated or not.

The prospect of struggling countries heading for the exits has added a new wrinkle to this trade.

Investors clearly want to be on the right side of any carve up: the German side. You don’t get a lot of yield in the bund or schatz markets nowadays, but, still, the chance of owning the bonds most likely to rise if the bloc splits is obviously worth enduring current miserable levels for.

However, there’s been the specter at this German feast for some time, even if very few market analysts have dared admit that they can see it.

Everybody’s scrambling for the same safe havens. We know the leading ones. But how safe are they really?

Gold seems to be at the top of most people’s lists. It’s as good as money, but central banks can’t print it into oblivion. It’ll always keep its value. It’s safe from government confiscation. Right?

Well, not really. Anyone who bought gold in 1980 suffered a hefty loss in real terms for more than two decades. The metal was a spectacular failure as a hedge against inflation during the 1980s and 1990s. And it’s not even safe from the government.

In 1933, the U.S. government forbade the hoarding of gold. Citizens were ordered to sell all but modest holdings of the precious metal to the Federal Reserve at a set price, or face 10 years in prison. The order didn’t survive court scrutiny, but it lasted long enough for 500 tonnes of gold to be handed over. What’s more, the legality of the U.S. government confiscating gold was upheld.

The European Central Bank has been buying ‘peripheral’ euro-zone debt in order to drive down yields for these countries and thus calm investor nerves.

But if the problem these countries face is a question of solvency rather than of liquidity, the ECB might well find itself owning vast swathes of sovereign debt even as yields remain high.

Here’s why.

Private investors have abandoned Greek and Irish debt and are nervous about Portuguese and Spanish sovereign paper because they’re worried about the prospects of being paid back. Remember, for bond investors there are two significant risks: default and inflation. In other words, the degree to which they’ll be paid back and how much the currency in which they’ll be paid back is likely to be worth.

To be sure, the ECB’s latest shock plan helped push down yields after the recent default panic that swept the continent’s fringes. Irish 10-year bonds, for instance, are yielding 8.2% now, a full 130 basis points down on the start of last week, and Spanish bonds are down some 60 basis points to 5.1%.

But these yields don’t really speak of much confidence in the markets that bond investors will get all their money back. That’s because there is a gnawing suspicion these countries will find it so hard to pay back what they already owe that they will ultimately choose to default.

For investors, it doesn’t matter that the ECB might be buying if they think the likely result of owning the paper will be a capital loss.

Irish and Greek sovereign debt yield spreads over German bunds have blown back out to the highs they hit at the worst of the European sovereign debt crisis earlier this year.

But these aren’t just special cases, related to Ireland’s endless rescue of its banking sector and Greece’s frankly hopeless fiscal mess. Credit default swap spreads, in essence the market price for insuring debt, on Spanish, Italian and Portuguese paper have also blown out over recent weeks. Not quite to the peak panic levels they reached — which forced the EU and the IMF to launch a $1 trillion package to rescue the euro — but not too far off either, and well above recent lows.

The latest bout of investor nervousness is down to a dawning realization that whatever the size of the short-term remedy, the longer-term problems with sovereign debt haven’t been resolved. The cracks are showing in the most vulnerable countries first, the second-tier euro-zone states being forced into deflation by a one size fits all monetary policy geared toward Germany. But the implications will eventually spread elsewhere …

Budget deficits are traditionally lagging indicators of what’s going on in the real economy, so it’s no real surprise to see that Germany’s deficit in the first half of the year more than doubled from the same time a year ago. Germany’s economy hit the bottom of a wrenching recession at the end of March 2009 -– something that also helps to explain the positively vibrant 3.7% annual growth rate reported earlier today for the second quarter by the Federal Statistics Office.

It should be good news for all concerned that Germany’s deficit, at 3.5% of gross domestic product, is turning out to be a lot smaller than the 5% forecast by the government at the start of the year. It appears the government will need to borrow less than planned in 2010, making fewer demands on the pool of available capital and leaving more to a private sector that seems increasingly willing to invest. Gross investment rose 4.7% from the first quarter of the year, although that’s exaggerated a bit by the fact that a lot of construction work was put off in the winter due to unusually cold weather. The prospects for a smaller state borrowing requirement have also helped drive down government bond yields to their lowest ever. The German 10-year bund yield hit a new low of 2.17% on Tuesday, and some analysts expect it to dip below 2% within weeks as the market prices in a slowdown in growth, and inflationary pressures, toward the end of the year. Amazingly, even though the deficit is one of Germany’s largest ever, it will be by far the cheapest one to fund.

As yields on long-dated government bonds collapse, investors would be wise to ask themselves whether they’re falling into the same valuation trap that has already burned them severely twice during the past decade.

That the previous carnage came in the equities market shouldn’t matter. The lesson is the same: ignore unlikely, but extreme, outcomes at your peril.

Ten-year German bunds are yielding just 2.24%, amid widespread forecasts they will test 2% before long. Ten-year Treasury notes offer a meager 2.55%, while two-year notes are on a historic low of 0.6%. U.K. gilts of the same maturity offer just 2.9%, even though inflation has been running well above the government’s 2% target for most of the past five years and is expected to do so for most of the next two years as well. And in Japan, 10-years are back below 1%.

For Keynesian economists like Princeton’s Paul Krugman, these low yields are the best evidence of a lack of aggregate demand across much of the developed world and portend a double dip and consequent slump into debt deflation. For them, Japan’s lost decades is the template of what is likely to happen: a long era of deflation and paltry growth with frequent bouts of deflation.

In such a case, bonds, even long-dated issues, offer real value for sensible, cautious investors. Little wonder then that U.S. retail investors have been fleeing equities for the safety of bonds or that some are hoping for the reintroduction of ultra-long issues, the 100-year bonds. Were this flight to spread to professional investors, the bond market could see an even more considerable spike.